Comparing Retirement Saving via Traditional and Roth IRAs, and HSAs
By Olivia Theveny, JD
Although your financial organization may not be equipped to provide individualized financial advice, it is important to have a working knowledge of the fundamental rules that apply to the retirement savings and other tax-advantaged accounts that you offer. You can further provide superior customer service by sharing general information about the advantages and disadvantages of three common tax-advantaged savings accounts and why some clients may benefit more from using one type of account over another when saving for retirement.
Traditional IRA
Advantages: Possible income tax deduction for contributions; potential tax credit for lower income individuals (saver’s credit)
Drawbacks: Required minimum distributions (RMDs); taxation of all deductible contributions and all earnings at time of distribution
Your clients who have higher incomes may reap greater benefits from the potential to deduct their contributions to a Traditional IRA and postponing paying federal income tax until later when they may be in a lower tax bracket. The ability to deduct a Traditional IRA contribution is phased out for individuals with modified gross income above certain thresholds if they, or a spouse, participate in an employer-sponsored retirement plan. Or, if they exceed the income limitations for contributing to a Roth IRA (see below), a Traditional IRA may be their only IRA savings option.
Roth IRA
Advantages: No RMDs; if qualification requirements are met, all earnings are tax-free; potential tax credit for lower income individuals (saver’s credit)
Drawbacks: Income limits for eligibility to contribute
Your clients who are in a low marginal tax rate benefit less from the potential to deduct a Traditional IRA contribution and, therefore, may find that a Roth IRA’s other advantages make the Roth IRA their preferred savings vehicle. This may include millennials, whose earning potential (and marginal tax rate) is likely to increase with time. Millennial clients also potentially benefit from saving with a Roth IRA because they have a longer amount of time before reaching retirement age, which will allow their savings to grow and, later, be distributed tax-free. A Roth IRA may also be appealing to those clients with a higher risk-tolerance, those who may be looking to diversify nontaxable assets, and those who want to avoid RMDs.
HSA
Advantages: Pretax contributions; tax-deferred earnings; tax-free distributions for qualified medical expenses; no RMDs
Drawbacks: Certain health coverage eligibility requirements; less favorable for nonspouse beneficiaries
The health savings account (HSA) was designed to assist individuals with saving and paying for medical expenses not covered by their high deductible health plans. However, for those individuals who are eligible to contribute, the many advantages of HSAs make them appealing for use as a retirement savings vehicle.
HSA contributions made by or on behalf of the HSA owner generally are deductible—without the potential income limitations applicable to deductibility of Traditional IRA contributions. Employers may allow their employees to elect to contribute to an HSA on a salary-reduction basis through a cafeteria plan. These contributions are excludable from taxable income just like 401(k) plan deferrals (they are not deducted on one’s income tax return) and are free from federal income tax and other employment tax withholding (i.e., Social Security and Medicare taxes (FICA), federal unemployment tax (FUTA), and railroad retirement tax).
Like a Roth IRA, an HSA does not have any RMDs. Distributions from an HSA must be used for qualified medical expenses to be tax-free, and the definition of qualified medical expenses is broad. More importantly, there is no time limit on when the distribution needs to be taken after qualified medical expenses are incurred. As long as an HSA owner properly documents qualified medical expenses incurred over many years and the expenses were not paid for or reimbursed by another plan/arrangement (e.g., health insurance or a flexible spending arrangement), he may take a tax-free distribution in the amount of the expenses from his HSA at a later date.
After an HSA owner turns 65, he can take a distribution from his HSA for any reason without penalty, but, if not used for medical expenses, the distribution will be taxable, just as pretax distributions from a Traditional IRA would be.
From an estate planning standpoint, your HSA owner clients should be aware that their beneficiaries will not have all the same distribution options that are available for IRA beneficiaries. Nonspouse beneficiaries (other than an estate) must include the HSA in their income in the year of the HSA owner’s death.
Clients should always consult their competent tax advisor to determine which savings vehicle is best suited to their needs based on their personal circumstances.
